For emerging and frontier market portfolios to become leaders during the next five years, they need to put environmental, social and governance (ESG) are the centre of their investment philosophies, according to RWC Partners’ John Malloy.
Over the past 10 years emerging and frontier markets have generally lagged developed markets, shown in the graph below.
Performance of indices over the past 10yrs
Source: FE Analytics
But this was flipped on its head during 2020 when the MSCI Emerging + Frontier Markets index outperformed the MSCI AC World, S&P 500 and FTSE 100.
Performance of indices during 2020
Source: FE Analytics
Malloy, co-head of emerging and frontier markets at RWC Partners, said that it was “paramount” for emerging market portfolios to make ESG central in their investment philosophies to enable long-term development across the regions and to aide emerging markets in continued outperformance.
He said: “On a global scale, emerging and frontier markets account for the largest share of the world’s population, land and mineral resources. They are the drivers of global growth and consumption. Sustainability is a function of their development and it is therefore essential to promote responsible business practices, enforce human rights and environmental protection.”
Malloy added that ESG considerations are “vital” when investing in developing countries: “If the next five years are to be the years of emerging and frontier markets, they will also be the years of ESG.”
His colleague James Johnstone, manager of the Luxemburg-domiciled RWC Next Generation Emerging Markets Equity fund, agreed with this sentiment, adding: “Ultimately I think it's all incredibly important for the future.
“I don't think [we] really disassociate the E, the S or the G. I think, again, these are things which you always should always have always been in in peoples’ minds.”
According to Johnstone, RWC firmly believes that the best returns will be achieved by investing in companies that have got a strong ESG proposal.
Looking at investment opportunities and Johnstone highlighted what appears to be a counterintuitive part of the market: mining and extraction companies.
He argued that as China and the US shifts their infrastructure policies towards better climate change practices, this will increase the demand for the commodities needed in that energy transition.
Emerging markets are very a rich supply of mineral resources, including elements such as copper and lithium, which are essential for making the batteries in electric vehicles, for example.
Johnstone explained that for a global shift into renewable energy to happen this will require some natural commodities which have to be extracted.
“Extractive industries have a very poor reputation. But it's obviously notable that BHP is now the biggest company in the FTSE 100.
"So the world has to be quite pragmatic in the way it views extractive industries," Johnstone said.
When selecting companies to invest in, Johnstone explained that he wants to pick the mining companies which are at the “pinnacle of ESG standards.”
He added: “So within our remit we want to make sure that we invest in the right metal or the right parts of the environmental climate change process. But at the same time that we want that company to be right at the pinnacle and to operate as cleanly as they can.”
When it comes to ESG and sustainable investment in emerging markets, Johnstone said that there is often a misunderstanding that emerging market companies are going to be bad on an ESG front and developed market options are going to be ‘good’.
“I'm often going to correct people when they say [that] because it wasn't a Vietnamese car manufacturer that falsified their diesel emissions,” he said. “There's always going to be scope for governance issues around the world.”
Johnstone said that over the past 30 years the bar for political stability, economic development, governance, environmental, social standards was set very high by developed markets.
But now he thinks that gap between developed and emerging markets has closed.
“I think what's happened is emerging markets have accelerated towards the kind of the practices of the West, but actually the West in many ways has slipped. I mean, there have been far more big corporate governance scandals across the developed world than they have really been in the emerging market world,” Johnstone said.
This means that it is no longer simple to say that one market is good or bad from an ESG standpoint because they both have good and bad examples.
In his own investment process, Johnstone said he’s looking for the “really exceptional cases of where management can drive the vision”. He pointed to Tencent or Taiwan Semiconductor Manufacturing Company (TSMC) as examples of companies which can attribute significant growth to strong governance practices.
Giving his outlook Johnstone said that the backdrop for emerging markets looks “very strong”, coming out of 2020.
“With a strong global economic recovery, obviously led by fiscal stimulus, we would anticipate that strong GDP rebound to be accompanied probably by a slightly weaker US dollar,” he said.
“And obviously, the growth rates in emerging markets or the recovery in emerging markets continue to be much stronger than the West. So you've got cheaper valuations in emerging markets, you've got strong earnings growth, and you've got a weaker dollar, which is normally a very good mix for emerging markets.
“And on top of that, we do see this this energy transition, the decarbonisation story driving the demand for some of these very important commodities. And that again, is very beneficial to emerging markets.”
Johnstone added: “So you combine that with the ability for some of these economies like Vietnam and India to leapfrog straight to renewable power, the next couple of years should be incredibly exciting for emerging markets.”